How Life Insurance Works

Of all of the financial decisions to be made in a lifetime, buying life insurance is probably the last one on anyone’s to-do list.

Insurance is boring enough by itself. Add in the fact that you’re buying something that will only be used when you die — and not by you — and it’s easy to see why buying life insurance is something most people would like to forgo.

Seventy percent of Americans say they need life insurance, but 41 percent of people don’t have it, according to a 2016 Trends in Life Insurance Ownership study.

The problem may start with understanding how life insurance works. In that life insurance industry study, 83 percent said they would consider life insurance if it was easier to understand.

Why buy life insurance?

Life insurance is a selfless purchase. The biggest reason to have it is to replace your income and prevent your family from suffering a financial crisis.

Here are some other things life insurance can pay for:

College for your children.

Funeral costs and other final expenses

A mortgage and other loans.

Credit cards and other debts that your family can’t afford.

Estate taxes.

Your spouse’s lifestyle, even if you don’t have children.

Create an inheritance for your heirs.

Make significant charitable contributions.

Life insurance can also be used to build wealth for your family. If you buy a policy when you’re young and healthy, it can save you money during your lifetime by locking in a lower rate.

You may only need life insurance for a certain amount of time, such as the length of your mortgage so your home can be paid off when you die and your spouse and children can live there. Or you may want a policy to last until after your children have moved out and have graduated from college.

Types of life insurance

An insurance policy is a contract between you (the policyholder, or the insured) and an insurance company. You agree to pay a premium to the insurer and if you die during the term of the policy, the company will pay the predetermined amount to the beneficiary you have chosen.

When educating yourself about life insurance, don’t feel like you have to become an expert in it and know every insurance term’s full definition. Let a good insurance agent help you with any questions you have.

When educating yourself about life insurance, you don’t need to be an expert. Let a good insurance agent answer your questions.

Still, it can be smart to know some of the basics before starting your search for a life insurance policy that’s a good fit for your needs. An agent can explain the ins and outs of different types of life insurance, but basically there are two types: term and whole life insurance. The first is for a set period of time and the second is for your entire life.

Term life insurance explained

Term life is the most common type of life insurance bought because it’s affordable for most people. It’s cheaper than most other types of life insurance because the coverage is for a certain policy term, such as 10, 20 or 30 years, and is only paid out if the insured dies during that time. When the term expires, so does the coverage.

It’s mainly used to protect your dependents if you die early. Say that you just got married and are buying a house with a 30-year mortgage. You may only want enough life insurance to cover the mortgage and your spouse’s living expenses during that time. Or a few years later you have children and you want to extend the term through their college graduation.

Once the term for a policy is set, most policies keep the payout (also called the death benefit) and the premium (how much you pay) the same throughout the term. You can be billed monthly for the premium, though if you miss a payment the policy can be revoked.

The idea behind term life insurance is that your family will no longer need it when the term expires. Your home will be paid off, you’ll have plenty of money in savings to cover a spouse’s expenses, and your children will be out on their own.

Whole life insurance

The other main type of life insurance is whole life, also called a permanent life insurance policy. It covers you for your whole life. Get it?

Whole life is a little more complicated than term. One big difference is price. Whole life premiums can be 10 to 20 times the price of term because coverage lasts a lifetime and will definitely be paid out (if all of the conditions of the policy are met), while term won’t be paid out if the insured doesn’t die during the covered term.

The premium remains the same during your lifetime, providing you a fixed cost that you can budget for each month.

Whole life insurance comes with a cash value, which is a guaranteed rate of investment return on a portion of the money you pay in the premium. The cash value grows slowly and is tax-deferred, meaning you won’t pay taxes on its gains while they’re accumulating.

You can borrow money against the policy or surrender the policy for cash. If you don’t repay the policy loans with interest, the death benefit will be reduced. If you surrender the policy for cash, the coverage ends.

While the cash value account of a whole life insurance policy grows at a guaranteed rate, there are some whole life policy that have other financial benefits. Some earn annual dividends, which can be taken as cash, left in the account to earn interest, used to decrease your premium, repay policy loans or buy additional coverage. Dividends aren’t guaranteed.

Term life can be enough for most families. But some may have needs for the permanent coverage of a whole life policy, including:

Paying estate taxes.

No need to sell off heirlooms or property to pay the tax bill if whole life policy provides enough money.

Lifelong dependent, such as a child with special needs who will need care after you die.

Insured can spend their retirement savings and still leave an inheritance or money for final expenses such as funeral costs.

Equalizing inheritances. If you leave a business or property to one child, a whole life policy can provide other children money to compensate for it.

Medical issues and buying young

Buying life insurance in your 20s is cheaper than it is in your 50s. Why? There’s more risk to insuring someone older who may have more medical problems.

Many life insurance policies require applicants to take a medical exam. The results can determine if a policy is offered and at what cost to the insured. The person with no medical issues or nothing serious in their medical history will have more insurance options than someone with such issues.

If you’re planning on getting married or having children, it can pay to get healthy and avoid a high life insurance premium. Once you’ve passed the medical exam and get a good rate on life insurance, then you can go back to smoking because the insurer won’t require another exam during the policy term.

It can also pay to avoid risky hobbies such as scuba diving, race car driving and hang gliding, which can lead to death benefits being excluded if you participate in such activities. Being at your best weight, not drinking to excess and not smoking can also result in lower premiums.

Buying more security with riders

If you’re unsure whether to buy term or whole life insurance, consider that most insurance companies provide free riders that allow a term policy to be converted to a permanent life insurance policy.

Be sure to ask if converting the policy requires taking a new medical exam.

You may want to switch from term to whole if a medical condition in your family history appears in your annual medical checkup, such as cancer. A term conversion rider allows your policy to be changed to permanent without having to reapply and possibly be turned down for a preexisting condition or the need for a medical exam.

There are also insurance riders that can be bought for a monthly fee that go beyond the normal coverage in your policy.

Most companies insure you for any cause, including death in an accident. You can buy extra coverage through a rider for a larger payout if you die from an accident.

If you become disabled, a waiver of premium rider can be used to transfer the cost of your monthly premiums to your insurance company. In other words, your remaining life insurance is free. However, there are health and age qualifiers and the rider may only last until retirement age.

A combination of policies

An insurance agent or broker may suggest having a combination of policies. You may want to ladder policies so that you have certain terms covered at certain amounts.

For example, a term life insurance policy for 10 years and $250,000 in coverage may be smart if you plan on paying off your home in 10 years or your children will be finishing college during that time. With your house and college paid off after those 10 years, you may need less coverage and may want $150,000 in term life insurance for another 10 years.

However, you may also want a $100,000 whole life policy to cover your funeral expenses, debts and any immediate needs your spouse may have when you die.

A good insurance agent can help you combine policies or find a few that fit your needs as your life changes.

Shop around for the best life insurance rates. A broker can check different policies and companies for you while helping you analyze your needs.

Hopefully, it will be something your family won’t need for many years to come. But when they do, they’ll be glad you checked this task off your to-do list.

About the author

Aaron Crowe

Aaron Crowe is a journalist who specializes in personal finance. He has written for AOL Real Estate, HSH.com, US News & World Report, Wisebread, LearnVest, AOL Daily Finance, AARP, Wells Fargo, Allstate, the USC Marshall School of Business, and Credit.com, as well as other insurance, credit and investment websites.